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Substitution Effect
A substitute is a good that satisfies the same need as another good, e.g., broccoli and cauliflower. The substitution effect states that a good becomes more of a bargain relative to other goods as its price declines; therefore, the good is substituted for other goods. For example, if the price of broccoli rises from $3 to $5 while the price of cauliflower remains constant at $3, households will be more inclined to consume more cauliflower and stay away from broccoli.
Income Effect
The term income effect, in economics, refers to a change in the consumption of a good or service due to a change in income. It is important to note that the income effect mainly expresses how increased purchasing power affects consumption. For example, if a CFA candidate’s income rises from $50,000 to $65,000 after passing the CFA level 1 exam, he will have more money to spend on rent, clothes, etc.
Examples: Substitution and Income Effects
A good example for understanding the substitution effect is that of public and private colleges. Many students avoid private universities because they are too expensive for them to afford. However, a slight decrease in the tuition fees in private universities will motivate more students to attend private universities.
On the other hand, the income effect could also affect the demand for private education. If the economy is booming, the students (or their parents) will have disposable income, which they might use to pay for their tuition in private colleges. In this instance, the demand for private universities will increase.
Real Income
While calculating the income effect separately from price effects, real income (income adjusted for inflation) is kept constant. As a result, there are different ways in which these two effects impact consumer behavior and businesses.
Wages, Interest Rates, and Savings
It is important to understand how income and substitution effects impact wages, interest rates, and savings. When wages increase, work becomes more profitable due to the substitution effect. An increase in wages also enables workers to maintain a decent standard of living by working less, which relates to the income effect. Similarly, higher interest rates cause an increase in income from savings which is another income effect. When savings become more attractive as compared to spending, consumer spending reduces.
Question
What will be the impact on the consumption of a good if the substitution effect of that good is positive and the income effect of the good is negative but smaller than the substitution effect?
- Consumption of that good increases.
- Consumption of that good decreases
- Consumption of that good can either decrease or increase.
Solution
The correct answer is A.
A positive substitution effect implies that consumers can still afford a good or a service even if the good or service price increases or the consumers’ income declines. A negative income effect implies that an increase in consumers’ income will decrease the demand for that particular good or service.
A negative income effect that is smaller than the substitution effect and a positive substitution effect that is overriding the negative income effect implies that if the consumer’s income increases or the good or service price increases, there will be an increased demand for the good/service.
Sergio Torrico
2021-07-23
Excelente para el FRM 2
Escribo esta revisión en español para los hispanohablantes, soy de Bolivia, y utilicé
AnalystPrep para dudas y consultas sobre mi preparación para el FRM nivel 2 (lo tomé una sola vez y aprobé muy bien), siempre tuve un soporte claro, directo y rápido, el material sale rápido cuando hay cambios en el temario de GARP, y los ejercicios y exámenes son muy útiles para practicar.
diana
2021-07-17
So helpful. I have been using the videos to prepare for the CFA Level II exam. The videos signpost the reading contents, explain the concepts and provide additional context for specific concepts.
The fun light-hearted analogies are also a welcome break to some very dry content.
I usually watch the videos before going into more in-depth reading and they are a good way to avoid being overwhelmed by the sheer volume of content when you look at the readings.
Kriti Dhawan
2021-07-16
A great curriculum provider. James sir explains the concept so well that rather than memorising it, you tend to intuitively understand and absorb them.
Thank you ! Grateful I saw this at the right time for my CFA prep.
nikhil kumar
2021-06-28
Very well explained and gives a great insight about topics in a very short time. Glad to have found Professor Forjan's lectures.
Marwan
2021-06-22
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Benjamin anonymous
2021-05-10
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Daniel Glyn
2021-03-24
I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
michael walshe
2021-03-18
Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.